Take Your Portfolio to See ‘Hunger Games’

Recommendation:Buy Lions Gate Films between $14-$15 per share.Options Alternative: Buy to open the LGF Dec. 14 Calls for $1.50 per share or less.

Lions Gate Films (NYSE:LGF[1]) reported earnings last week with two very big surprises: First, revenue was up more than 80% year-over-year. But second, net earnings swung to a loss and missed expectations by 42 cents per share. That’s a big miss for a firm with a $14 stock price.

The source of the surprisingly high revenues and worse-than-expected profits was the same: increased marketing and promotions in an attempt to boost second-half performance in 2012.

In just one example, LGF controls the incredibly profitable Hunger Games franchise — and spent an incredible amount of money, too, in promoting that film over the last quarter. The strategy was simple: Make sure the first film was a resounding success so that the rest of the trilogy could rake in the profits.

The first part of that strategy appears to be working. Massive box-office sales have made the Hunger Games the 12th-highest grossing film of all time. Will the other two films be as productive? We think so. But more important, we think they’ll be much more profitable.

In fact, CEO Jon Feltheimer said as much in the company’s earnings call on Aug. 10. He reported that fully two-thirds of the profits from the first Hunger Games film have yet to be realized. (As far as “forward-looking statements” go, we think that’s a good one!) While the numbers are smaller, the profit potential for the final Twilight film is similar.

Management reiterated that LGF is on track for end-of-year guidance and that the third and fourth quarter of 2012 will see better performance than the first two quarters of this year.

Let’s not forget, the company also has a great portfolio of TV properties, including Mad Men, Weeds and the developing Anger Management and Boss series. Although the marquee names associated with LGF are usually found in its theatrical releases, most of the firm’s revenues come from TV and home consumption of those movies. Growth in international revenue is taking a more significant role as well.

It’s true that those forward-looking statements from the CEO are probably already built into the current stock price. However, keep in mind that the current market environment has kept overall prices low because most investors are overlooking LGF’s spending for growth. We consider buying LGF a classic contrarian play because the firm is taking risks for growth, while the market as a whole remains flat and risk-averse.

It wouldn’t be prudent to fill a portfolio full of stocks like this, but as part of a balanced approach, we think buying a few risky stocks with strong potential is a great idea.

Global economic weakness has also created some negative pressure on the stock over the last several months. Like most other growth stocks, LGF sold off following the March rally when economic conditions in Europe and Asia began to deteriorate (again). The next chart compares LGF with two ETFs that track emerging markets (EEM) and European large-cap stocks (IEV). You’ll notice that recently the stock formed a higher low after the earnings release and has been tracking international stock higher.

The international and domestic growth stock markets broke out in December 2011 and again in January 2012 before topping out in March, by which point LGF had doubled in price. We have also noticed that rallies in LGF have historically been more likely to occur toward the second half of any year because the company tends to commit resources early in the year preparing for those latter (more important) quarters. We expect this pattern to continue this year as well.

Finally, the short-term technicals are also confirming the potential for a continued breakout this quarter. The stock bounced off support between $13-13.50 early this week and broke through to over $14. Although there is some short-term potential resistance near $15 per share, a continuation of the prior trend could hit $16.50-$17 per share by the next earnings report (indicated by the green bar on the next chart).

Earnings estimates have already been raised 82% for the next quarter — which is dramatic, and very unusual among LGF’s peer group.

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Lions Gate Films (LGF)Chart courtesy of MetaStock </p>
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Earnings estimates for next quarter are higher than they were for the first quarter of 2012, when the stock was priced at $16 per share. There is also a strong consensus estimate that revenue in 2013 will finally start to rise after remaining flat for most of 2010-2012. Those estimates are likely to be confirmed next quarter and could send the stock over $20 per share quite easily if global economic conditions ease.

In short, we love finding undervalued but aggressive firms like this during a soft market.

An Option Alternative:

We also like the idea of buying the LGF Dec. 14 calls for $1.50 per share or less. Call buyers have been very active in the long-dated options for many of the same reasons we have written about here. The advantage of the calls is that less total capital is put at risk if there is unusual volatility between now and the end of the fourth quarter.

Keep in mind that because this is a smaller firm, the options have a wide spread, but a limit order placed between the bid and ask should be filled for patient investors.

If the stock meets our price objective of $17 by October, the options would have gained in value by at least 100% — and could be worth even more, if the move we’re expecting takes place in the short term.